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July 26, 2010

GAO Report Identifies Life Settlement Risks

Transparency, regulatory inconsistency among concerns

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The Government Accountability Office (GAO) recently released a report determining that regulatory inconsistencies governing life settlements pose a number of risks for consumers and brokers.

The report notes that there is no comprehensive data for life settlements, but estimates that the market "grew rapidly from 1998 until the recent financial crisis."

After increasing from 2006 to 2008, the number of policies settled declined in 2009, the report found. In 2009, over 2,600 policies were settled with a total face value of $7.01 billion, down from 4,505 in 2008. Policy owners were paid a total of $890 billion and brokers made $90 million in commissions from the sale of life settlements, in 2009. In 2008, the total value of policies settled was nearly $13 billion. Policy owners were paid more than $2 billion and brokers' commissions were $280 million.

Life settlements are regulated by state insurance laws, which oversee the "front-end transaction," or the sale of a policy by its owner to a provider; and by state and federal securities laws which regulate the "back-end transaction," or the sale of the policy to an investor from the provider.

As of February 2010, 12 states and Washington, D.C., have yet to establish laws regulating life settlements. Variable life policies are subject to regulation by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA); however, conflicting opinions from U.S. Courts of Appeals for the District of Columbia and the 11th Circuit have limited the SEC's jurisdiction over life settlements involving other types of insurance policies.

Challenges identified in the report are a consequence of regulatory inconsistency. Policy owners in some states may be less protected than those in other states, and consequently may have more difficulty accessing important information. Furthermore, differences in court decisions and state laws about whether life settlements are securities may prevent investors from getting information they need about their investments.

Brokers and providers suffer from inconsistencies between states, as well. Regulatory differences increase compliance costs, the report found, and impede brokers' ability to do business in some states. Sellers that operate in multiple states may need to maintain different application and disclosure forms, or file different data in different states; they may also need to go to different regulators for approval.

Stranger-originated life insurance poses a further threat to policy holders, insurance companies and investors. Policy holders run the risk of incurring taxes on income from the transaction, disputes about the validity of the policy, and potentially being denied additional life insurance. Threats to life insurance companies include costs in "deterring, detecting, or litigating" policies, while investors are in danger of losing their investment should a policy violate insurable interest laws.

The GAO recommended that Congress ensure policy holders are "provided a consistent and minimum level of protection."

SEC Chairman Mary Shapiro agreed with this recommendation in a letter published with the report, and called for "enhanced investor protections" to be introduced to the life settlements market.

The National Association of Insurance Commissioners, however, disagreed with the suggestion that a federal charter for insurance would be an appropriate response to the threats outlined in the report.

"Upending the existing system of state-based insurance regulation in favor of a federal charter option makes no sense given the success of the state regulatory system in the face of ongoing financial crises," the NAIC wrote in a letter to the GAO, which was included in the report. The NAIC claims state officials have effectively regulated the insurance market to keep up with "the needs of the modern economy" and argues that federal chartering would ultimately harm consumers.